In his post, “Are Equities Overvalued“, Ashok Rao wrote,
On the other hand, extremely low interest rates – not just in Treasuries, but safe(r) assets in general – suggest anxiety about future growth. If growth potential really is so fantastic, it doesn’t make sense to crowd into risk-free assets that have almost no claim on that growth. One explanation could be a decline in the risk premium, which militates in favor of the “lethargic and stagnant” view – that we’ve rerated valuations with a lower discount rate, but shouldn’t expect exceptional growth.
A decline in the risk premium would suggest a host of projects that were otherwise unprofitable become feasible, resulting in increased business investment across the board. This may be the case (and we can’t examine the counterfactual) but, somehow, this doesn’t sit well with the prevalence of cash and highly liquid assets piling up on corporate balance sheets.
One simple (if unsatisfying) explanation might be that markets aren’t efficient. There are two types of inefficient. The sort that persists temporarily, and that is bidded away as investors and arbitrageurs profit on the discrepancy, and the sort for which there isn’t an obvious correcting mechanism. The latter, I would argue, is rarer but one can definitely contrive explanations that make sense of the situation.
A possibility that I find appealing stems from a simple principal-agent dilemma. The risk profile for high-level managers (who are – as a baseline – compensated extremely well) aggressively pursuing projects that become viable on the margin is asymmetric. If lots of cash is lost, the manager risks his job. If it succeeds, given that it is a marginal investment, the effect on his bonus would be minimal. The literature on CEO salaries outlines incredible bonuses as an incentive to take big risks – but big risks with big payoffs (and big losses), not necessarily those that are merely better than nothing.
The post suggests that the reason why the hurdle rate is so high is because of the principal-agent dilemma and the reluctance of managers to undertake projects with lower returns. As opposed to the usual example of empire-building, this is the opposite malady, i.e. timidity. Hence the question that begs to be asked is, is it a matter of incentives?
If everyone is a short-term shareholder, it may appear that incentives are in fact not misaligned. However, companies may eventually run out of room for managing earnings and balance sheets, exposing the holders at that moment to potentially large price decline.
This thinking echoed the notes from the OECD Business and Finance Outlook 2015,
It was noted earlier that capital expenditure by companies appear to have a higher hurdle rate than for financial investors. There are two fundamental reasons for this.
First, real investors have a longer time frame compared to financial investors who believe (perhaps wrongly at times) that their positions can be quickly unwound.
Second, managers of MNEs operate in a very uncertain world and the empirical evidence suggests that equity investors ‘punish’ companies that invest too much and reward those that return cash to shareholders. If managers make an error of judgement they will be punished by activist investors and/or stock market reactions in general and hence they prefer buybacks.
The low interest rates have encouraged financial risk-taking, but perhaps more ‘real-economy’ risk-taking should also take place. This applies equally to physical capex as well as the increasingly important spending on intangibles, which has not shown much growth either. In the OECD note,
Driving up share price (or defending a fall) to push stock options ‘into the money’ (or keep it there) increases the personal gain of executives, while reducing the scope for investment.
So if managers are incentivised to keep EPS artificially high, then it goes to follow that the price of equity would remain high as well. What does it mean for the long term prospect of businesses and ultimately the economy should this trend continue? And what are the implications for the equity risk premium?
As found in the survey by John Graham and Campbell Harvey, “The Equity Risk Premium in 2015“,
We analyse the history of the equity risk premium from surveys of U.S. Chief Financial Officers (CFOs) conducted every quarter from June 2000 to March 2015. The risk premium is the expected 10-year S&P 500 return relative to a 10-year U.S. Treasury bond yield. We show that the equity risk premium has increased more than 50 basis points from the levels observed in 2014. The current 10‐year risk premium is 4.51%. Similarly, measures of risk such as investor disagreement and perceptions of volatility have increased. Interestingly, the increased premium and risk are not reflected in market‐based measures of risk, such as the VIX and credit spreads. We also link our survey results to measures survey‐based measures of the weighted average cost of capital and investment hurdle rates. The hurdle rates are significantly higher than the cost of capital implied by the market risk premium.
It was found that these hurdle rates are, on average, 400 basis points higher than the reported WACCs.
The real question then is whether managers are correct in their reluctance to invest. A look at capacity utilization suggests that they may be:
Capacity utilisation is still recovering and far from its peaks. At the same time nominal GDP growth remains very weak, which directly translates into dampened sales growth expectations.
Alongside with increased international competition, it is therefore rational for managers not to over-invest because this could lead to ruinous price competition. On top of this, research has shown that broad market ownership by large asset managers and in particular index trackers creates incentives against fierce competition and in favour of aggregate profit maximization (just short of outright collusion).
To conclude, it appears that the cards are quite heavily stacked against a new wave of capital expenditure, no matter where interest rates end up.